Banks use the Debt Service Ratio to assess your creditworthiness.
Defined as the monthly loan installment amount divided by your gross monthly income, your DSR typically has to be somewhere in the 35% to 40% region for banks to be happy to grant you that mortgage. (See also past article on second home loan.)
However, the DSR ratio doesn’t say if you’re taking up excessive loans.
You may have a low overall DSR, but due to low interest rates and long mortgage tenors, you may be piling up too much loans. Or maybe your income has just gone up (how nice) , but with savings still remaining low, your DSR may look deceptively good.
It is even possible to have negative net worth with good-looking DSR. Banks don’t care, but I hope you do.
To be safer, you should also look at your Debt to Net Worth ratio.
This is similar to the Debt Equity Ratio used by financial analysts to assess companies. Small companies with 60% D/E are deemed to be ok.
I would keep my Debt to Net Worth ratio at 50% or lower.
Calculating your Debt to Net Worth ratio is straightforward: Total up your outstanding loans, and divide the sum by your net worth (see how to calculate your net worth).
For example, if your outstanding loans sum up to $500k and your net worth is $1 million, your Debt to Net Worth ratio would be 50%.
What is your Debt to Net Worth ratio?